Introduction to the Industrial Sector: The Industrial sector is primarily comprised of companies that produce goods used in construction and manufacturing. Some of the key subsectors include aerospace and defense, construction and engineering, building products and industrial conglomerates. For the most part, these are capital-intensive industries that often operate on low or even razor-thin net margins. Consequently, profitability can be very erratic from one year to the next. Therefore, although there are exceptions, finding quality buy-and-hold dividend growth stocks in this sector is tricky.

Moreover, companies in this sector tend to be very sensitive to the general state of the economy. For example, residential, commercial and industrial construction tends to weaken during recessionary periods. Consequently, there are many companies in this industry that are cyclical, or perhaps more precisely stated, have very inconsistent, unpredictable and erratic earnings histories.

Therefore, as I reviewed this industry I also saw similar patterns in many industrial companies’ long-term dividend records. In other words, during periods of weak earnings, the dividends paid by companies within this sector are often cut. Consequently, prospective investors seeking opportunities in this sector need to be very discerning. In spite of what I just wrote, there are a lot of high-quality names that are currently in value to be found.

The Industrial Sector

This is the fourth in a series of articles designed to find value in today’s stock market environment. However, it is the third of 10 articles covering the 10 major general sectors. In my first article I laid the foundation that represents the two primary underlying ideas supporting the need to publish such a treatise. First and foremost, it is not a stock market; rather it is a market of stocks. Second, regardless of the level of the general market, there will always be overvalued, undervalued and fairly valued individual stocks to be found.

As a refresher, my focus in this and all subsequent articles will be on identifying fairly valued dividend growth stocks within each of the 10 general sectors that can be utilized to fund and support retirement portfolios. Therefore, when I am finished, the individual investor interested in designing their own retirement portfolio should find an ample number of selections to properly diversify a dividend growth portfolio with.

With the above second notion in mind, this article will look for undervalued and fairly valued individual companies within the general sector 20-Industrials. Within this general sector, there are several subsectors which I list as follows:

My Selection Methodology

Before I go any further, an important disclosure is in order. I will produce a list of companies in this article (and all subsequent articles), that are names that I have hand-selected from a much larger universe. My selections were made by reviewing the individual earnings and price correlated F.A.S.T. Graphs™ on all appropriate companies that I identified within the sector. Some might say my method of identifying them was not very scientific, but I would counter that it was very thorough and comprehensive. On the other hand, I will admit to it being somewhat arbitrary and based on my own judgments.

Here is the basic method that I utilized. In order to find undervalued or fairly valued companies within the Industrial sector, I utilized the assistance of the F.A.S.T. Graphs™ screening tool in the following manner. First, I asked the screener to only look for companies within the sector 20-Industrials. Then I asked to search for any company within the sector that had a current dividend yield of 2% or better. Finally, I included ADRs and all companies listed on the Canadian stock exchanges.

This produced a gross list of 157 individual companies. Then I created a personal portfolio comprised of these 157 individual companies and sorted them in alphabetical order. Next, I reviewed the individual graphs of each company and either rejected it or added it to my final lists of potential candidates based on whether or not I felt it had an adequate history and a reasonable level of consistency within that history. But most importantly, I looked for companies that I felt were reasonably valued, or close to it, today based on current earnings and expected future earnings growth. Then I broke my refined lists into two categories:

1. Conservative Growth and Income – 38 companies made this list.

2. Aggressive Growth and Income - 37 companies made this list

Before I present each of these lists, and featured selections from each, it’s important that the reader understands that these are prescreened lists of potential candidates prior to the necessary morecomprehensive research effort. In other words, I am not recommending any of these stocks for current investment. Instead, I am recommending them as companies with historical records that appear reasonably valued, and therefore, worthy of investing the time and effort to take a closer look at. This presented a challenge in finding aggressive candidates within the Industrial sector because of the cyclical nature of many of its constituents.

The Industrials Sector: A Propensity for Erratic and Unpredictable Operating Records

Before I present my list of companies in the Industrial sector that I felt were worthy of future research, I thought it might prove useful to present a few examples of companies that were cut or excluded. Keeping in mind that this is a series of articles looking for high-quality dividend growth stocks amongst the 10 primary sectors, a consistent and growing dividend was a major requirement for inclusion in my lists.

Since a picture is worth 1000 words I will again turn to F.A.S.T. Graphs™ and present the following two graphic examples of reasonably well-known companies in the Industrial sector with spotty operating histories and dividend records. For those not familiar with these earnings and price correlated graphs, I suggest focusing on two of the lines that the graphs reveal. The first is the orange earnings justified valuation line. Note that in both of these examples the lines depict erratic historical earnings results that go beyond being merely referred to as cyclical.

The second important line as it relates to this article is the pink line which plots dividends per share. Notice how both companies have historical records of cutting their dividends. Since dividend growth investors are typically interested in a consistent and increasing dividend income stream, these were the types of companies that were easily excluded. However, and in fairness to the companies depicted, it is certainly possible that their future records could be better than the past. However, since limited time is a hallmark of most dividend growth investors, they must be selective as to where they spend it.

My list of aggressive Industrial dividend growth prospects are not offered for the faint of heart. Many of these selections are very small, and some have very short records of paying dividends. Nevertheless, I felt that there are some very interesting potential candidates within this group. The reader should keep in mind that this is a prescreened list that has not been extensively researched, and therefore, is offered only as depicting prospects for a deeper due diligence effort.

My first featured aggressive selection is US ecology Inc., a small cap with a high earnings growth rate and only a modest amount of cyclicality. I was also intrigued by the company’s high payout ratio perhaps indicating a very shareholder-friendly management team and Board. The company has a niche operation that I also felt might be interesting to the aggressive dividend growth investor. The following brief description is taken directly from their website:

“US Ecology is the nation’s most comprehensive supplier of cost-effective treatment and disposal services for low-level radioactive wastes, hazardous and PCB wastes and naturally occurring, accelerator produced and exempt radioactive materials. US Ecology takes pride in its excellent regulatory compliance record and long history of industry leadership.”

The following earnings and price correlated F.A.S.T. Graphs™ and the accompanying performance table clearly illustrates the incredible dividend record of the company since they initiated one in 2004. Add in a very high capital appreciation component, and total shareholder returns are quite attractive.

As far as the future is concerned, the consensus of three analysts reporting to Standard & Poor’s Capital IQ expect the company to continue to grow at 18% per annum going forward. Consequently, in spite of the small universe of analysts following the company, I felt this kind of potential was worthy of being singled out.

Balance Sheet

The following FUN (fundamentals underlying numbers) graphic looks at US Ecology Inc’s balance sheet on a per share basis. The following table lists the metrics and the acronym for each item. Therefore, at a glance we see that the company’s balance sheet has generally been strengthening in recent history.

Per Share Graph/Balance Sheet

Assets per share (atps)

Cash and equivalents per share (cashps)

Common equity or book value per share (ceqps)

Debt long-term per share (dltps)

Debt per share (dtps)

Invested capital per share (icaptps)

US Ecology Dividend Policy

Since this series of articles is focused on dividend growth stocks, the following excerpts from a recent press release shed light on the company’s board of directors’ attitudes toward shareholders:

“US Ecology Affirms Dividend Policy

BOISE, ID -- (Marketwired) -- 05/30/13 -- US Ecology, Inc. (NASDAQ: ECOL) ("the Company") today announced that its Board of Directors has reaffirmed the Company's dividend policy and intends to continue to pay an $0.18 per share quarterly dividend over the next year. The Board of Directors conducted its annual dividend policy review following the Company's annual meeting of stockholders in Denver, Colorado on May 30, 2013. "Management and the Board of Directors believe the current dividend level achieves a balanced use of our free cash flow, rewarding our stockholders while expanding our state-of-the art waste treatment and disposal capacity, supporting organic growth investments and allowing us to pursue complementary acquisitions in the coming years," commented Jeff Feeler, President and Chief Executive Officer. "With our industry leading return on invested capital of over 15%, we are committed to reinvesting in the business to generate attractive returns for our shareholders."

The following fundamentals in millions, FUN Graph, plots cash and equivalents (cash), and common shares outstanding (csho), providing further evidence of the shareholder-friendly nature of the company’s management and board as further reflected in this excerpt from its most recent quarter’s earnings report:

“The Company reported 18.4 million common shares outstanding and $4.5 million in cash on hand at March 31, 2013. Management estimates that approximately $3.3 million in cash will be paid out for each declared quarterly dividend. The next quarterly dividend is scheduled to be declared on July 1, 2013 and paid on July 25, 2013 to stockholders of record on July 17, 2013. Dividend declarations and payments will continue to be subject to quarterly financial review and compliance with applicable bank covenants.”

My second featured selection under my aggressive Industrial sector list is Finning International Inc., a Toronto Stock Exchange-listed Canadian selection that appears to be currently very undervalued. The company has an excellent long-term record of earnings growth, and in spite of its recent low valuation, this has translated into solid long-term shareholder returns. The following earnings and price correlated F.A.S.T. Graphs™ and associated performance report illustrates my point.

Balance Sheet

The following FUN (fundamentals underlying numbers) graphic looks at Finning International Inc.’s balance sheet on a per share basis. The following table lists the metrics and the acronym for each item. Therefore, at a glance we see that the company’s balance sheet has generally been very solid and even strengthening in recent history.

Per Share Graph/Balance Sheet

Assets per share (atps)

Cash and equivalents per share (cashps)

Common equity or book value per share (ceqps)

Debt long-term per share (dltps)

Debt per share (dtps)

Invested capital per share (icaptps)

Statement of Cash Flows

On the other hand, a graphical look at the company’s record of cash flows raises some red flags. The following table lists the metrics and the acronym for each item, and the following FUN graphic plots several key items from the company’s statement of cash flows as follows:

Cash Flow Statement

Capital expenditures per share (capxps)

Cash flow per share (cflps)

Dividends per share (dvpsp)

Free cash flow per share (fcflps)

Operating cash flow per share (ocflps)

The company’s erratic and inconsistent record of operating cash flow per share and free cash flow per share raise questions that should be answered before an investment is considered. However, consider that the free cash flow calculation is after dividends have been paid.

Conservative

I believe there are some very attractive conservative selections available in the Industrial sector. Although many of the names do have histories of moderate cyclicality, I would stop short of labeling any of them as purely cyclical. Instead, I like to think of them as quasi-cyclical. Most importantly, even though they display the occasional temporary periods of earnings drops, most of the names on the list have steady and consistent records of dividends and even dividend increases.

I chose Lockheed Martin Corp. as my first featured selection in my conservative group in order to respond to a series of comments that were posted on a F.A.S.T. Graphs™ article found here. These articles were prompted in response to a statement that Morningstar made on Lockheed Martin Corp. as follows:

“Morningstar has a comment about the budgetary pressures that "require the U.S. Department of Defense to reduce spending by nearly $1 trillion over nine years, including $487 billion from the Budget Control Act of 2011 and $500 billion from sequestration that began March 1, 2013. Lockheed would be hard-pressed to escape these large reduction requirements. In an attempt to maintain operating margins, the firm proactively reduced head count to 120,000 in 2012 from 146,000 in 2008."

Therefore, and for starters, I offer the following FUN graph showing that Lockheed Martin’s unfortunate reduction in headcount seems to be having the desired effect on the company’s gross profit margin (gpm) and net profit margin (npm). Consequently, early indications are that the company may be able to maintain profitability in spite of challenges within the defense industry. However, as I will cover in a moment, maintaining historical growth rates are a different matter altogether.

The following earnings and price correlated graph on Lockheed Martin Corp. shows that earnings growth has flattened considerably since the recession of 2008. From the long-term perspective presented below, it is clear that Mr. Market has also been discounting the company’s valuation in conjunction with the lower earnings growth rate (the black monthly closing price line is significantly below the orange earnings justified valuation line).

By focusing on Lockheed Martin Corp.’s more recent history, we discover that their earnings growth rate has been almost cut in half relative to their long-term earnings growth rate. Furthermore, this has created an adjustment in their normal P/E ratio (the dark blue line) to a normal PE of 10 in contrast to a longer-term normal PE of approximately 15. Consequently, I believe that the market has currently reset Lockheed Martin’s valuation. Stated more simply, I believe the concerns that Morningstar raised are currently factored into the company’s low valuation.

On the other hand, from a performance point of view, capital appreciation has certainly been affected by the current discounting of Lockheed Martin’s share valuation. On the other hand, shareholders can take solace in the fact that the dividend and the dividend growth rate have remained quite solid.

Balance Sheet

The following FUN (fundamentals underlying numbers) graphic looks at Lockheed Martin’s balance sheet on a per share basis. The following table lists the metrics and the acronym for each item.

Per Share Graph/Balance Sheet

Assets per share (atps)

Cash and equivalents per share (cashps)

Common equity or book value per share (ceqps)

Debt long-term per share (dltps)

Debt per share (dtps)

Invested capital per share (icaptps)

Therefore, at a glance we see that the company’s balance sheet, with the exception of assets per share (atps), has weakened during the last couple of years. This could be both a red flag, and an indication that the market’s current discounting policy on Lockheed Martin may be appropriate.

Statement of Cash Flows

Furthermore, a graphical look at the company’s record of cash flows raises some additional red flags. The following table lists the metrics and the acronym for each item, and the following FUN graphic plots several key items from the company’s statement of cash flows as follows:

Cash Flow Statement

Capital expenditures per share (capxps)

Cash flow per share (cflps)

Dividends per share (dvpsp)

Free cash flow per share (fcflps)

Operating cash flow per share (ocflps)

The concerns here are the deterioration in cash flow per share (cflps) and perhaps more importantly to dividend investors, the deterioration in free cash flow per share (fcflps). However, I remind the reader that this depiction of free cash flow per share is after dividends have been paid.

My final featured selection in the Industrial sector is United Technologies Corp., which is also my favorite, and one that I am long in. However, I should point out that United Technologies is currently technically fully priced, but not overvalued. On the other hand, I believe that patient investors might wait for a better valuation before purchasing shares. But, I would simultaneously caution that I believe this is a terrific company that I wouldn’t wait too long for. The following earnings and price correlated graph and associated performance table speak for themselves.

United Technologies - The Future

In addition to having a great track record, United Technologies is also expected to grow earnings at an accelerated pace going forward. Although this company is technically categorized in the subsector aerospace and defense, I believe this understates the earnings power that this diversified conglomerate possesses. The following outline taken directly from the company’s website illustrates the diversity of their product lines:

“United Technologies (UTC) is a diversified company that provides a broad range of high-technology products and services to the global aerospace and building systems industries. Our commercial businesses are Otis elevators and escalators and UTC Climate, Controls & Security, a leading provider of heating, ventilation, air conditioning, fire and security systems, building automation and controls. Our aerospace businesses are Sikorsky aircraft and the new UTC Propulsion & Aerospace Systems, which includes Pratt & Whitney aircraft engines and UTC Aerospace Systems aerospace products. The company also operates a central research organization that pursues technologies for improving the performance, energy efficiency and cost of UTC products and processes.”

Therefore, I believe the diversity of this company’s product lines is what has prompted the consensus estimates of 11 analysts reporting to Standard & Poor’s Capital IQ to forecast future earnings growth at 12.9%. Furthermore, a cross check from Zacks corroborates these estimates with their five-year expected growth rate of 12.6%. In other words, I consider this a consensus of consensus.

The following FUN graph on United Technologies’ common shares outstanding (csho) supports the above thesis for growth. I believe this also represents additional evidence of the shareholder-friendly nature of this blue-chip industrial company.

Balance Sheet

The following graphical look at United Technologies’ balance sheet illustrates that the company’s balance sheet is strengthening significantly. The recent acceleration of most of United Technologies’ per-share balance sheet metrics supports the consensus estimates for re-accelerating growth reported above.

The following FUN (fundamentals underlying numbers) graphic looks at United Technologies’ balance sheet on a per share basis. The following table lists the metrics and the acronym for each item.

Per Share Graph/Balance Sheet

Assets per share (atps)

Cash and equivalents per share (cashps)

Common equity or book value per share (ceqps)

Debt long-term per share (dltps)

Debt per share (dtps)

Invested capital per share (icaptps)

Statement of Cash Flows

Furthermore, a graphical look at the company’s record of cash flows provides additional evidence of United Technologies’ financial health and strength. The following table lists the metrics and the acronym for each item, and the following FUN graphic plots several key items from the company’s statement of cash flows as follows:

Cash Flow Statement

Capital expenditures per share (capxps)

Cash flow per share (cflps)

Dividends per share (dvpsp)

Free cash flow per share (fcflps)

Operating cash flow per share (ocflps)

The bottom line is that United Technologies is an extremely high-quality company exhibiting healthy financials and the possibility for above-average continued growth. The only negative associated with this blue-chip Industrial is that the current valuation is a little on the high side. However, as I stated earlier, United Technologies is not overvalued but perhaps only fully valued at today’s levels.

Summary and Conclusions

Companies in the Industrials sector might best be thought of as quasi-cyclical companies. The reason I refer to them as quasi-cyclical is to contrast them from when I would consider lesser attractive deep cyclicals. However, due to the industries that industrials operate in, they do show a high sensitivity to the health of the underlying economy.

One final thing that I would be remiss in not pointing out about this sector is that I see a lot of high-quality companies trading at low valuations. Although I only featured Lockheed Martin as an undervalued example, some of the undervalued standouts would include the following:

This is the fourth in a series of articles looking for quality dividend growth stocks at sound value amongst the various sectors. The next sector covered in this series will look for value in the sector 25-Consumer Discretionary.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

Disclaimers: GuruFocus.com is not operated by a broker, a dealer, or a registered investment adviser. Under no circumstances does any information posted on GuruFocus.com represent a recommendation to buy or sell a security. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The gurus may buy and sell securities before and after any particular article and report and information herein is published, with respect to the securities discussed in any article and report posted herein. In no event shall GuruFocus.com be liable to any member, guest or third party for any damages of any kind arising out of the use of any content or other material published or available on GuruFocus.com, or relating to the use of, or inability to use, GuruFocus.com or any content, including, without limitation, any investment losses, lost profits, lost opportunity, special, incidental, indirect, consequential or punitive damages. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. The gurus listed in this website are not affiliated with GuruFocus.com, LLC.
Stock quotes provided by InterActive Data. Fundamental company data provided by Morningstar, updated daily.